Fraud Risk

3 Fraud Risk Factors (conditions generally present for fraud to occur):

1. Incentive/pressure - reason to commit fraud
2. Opportunity - lack of effective controls
3. Attitude that allows the person to rationalize fraud - attempt to justify fraudulent behavior 

Types of Fraud:

1. Fraudulent Financial Reporting - LYING
• intentional misstatements/omissions of amounts/disclosures
• manipulation of accounting records
• misrepresentation in financial statements
• intentional misapplication of accounting principles 
2. Misappropriation of Assets - STEALING
• theft of assets 
• unreliable accounting system
• inadequate: internal control, management understanding, access controls, physical safeguard 
3. Corruption - CHEATING 

Going Concern & Uncertainty

Going Concern - Auditor's report presentation:

• Adequate disclosure: Unmodified with Emphasis-of-Matter paragraph
• must include terms: substantial doubt, going concern
• Inadequate disclosure: Qualified or Adverse
• Significant going concern uncertainty: Disclaimer 

Going Concern Mitigating Factors (intent & ability to execute):

• Borrow money or restructure debt
• Sell assets
• Delay or reduce expenses
• Increase ownership equity

Uncertainty

• No material misstatement & sufficient evidence: Unmodified
• Material misstatement related to uncertainty: Qualified or Adverse
• Insufficient evidence (scope limitation): Qualified or Disclaimer 

Evaluating for Attribute Sampling

• Sample deviation rate + Allowance for sampling risk > Tolerable rate
• bad result; cannot rely on control
• Sample deviation rate + Allowance for sampling risk < Tolerable rate 
• good result; can rely on control 

Definition:

1. Upper deviation rate = sample deviation rate + allowance for sampling risk
2. Tolerable rate of deviation =  highest deviation rate the auditor could accept & still conclude that the design and operation of an internal control is effective
• used in drawing conclusion on effectiveness of control
• based on auditor judgment
• compared to upper deviation rate
3. Sample deviation rate = (# of errors) / (sample size)

Ratios & Interpretations

1. Quick (acid-test) ratio
• formula: (cash + marketable securities + net receivables) / CL
• interpretation: immediate short term liquidity
2. Current ratio
• CA / CL
• short term liquidity
3. Debt to equity ratio
• Total liabilities / Common stockholders' equity
• degree of protection afforded to creditors in case of insolvency
• what proportion of equity & debt the company is using to finance assets 
4. Debt ratio = Total liabilities / Total assets 
5. Times interest earned
• recurring income before interest and taxes / interest
• ability to cover interest charges
6. Accounts receivable turnover
• Net sales / Net AR
• success (or lack of) in collecting outstanding receivables
7. Inventory turnover
• Cost of goods sold / Ave. inventory
• how quickly inventory is sold 
8. Total asset turnover
• Net sales / Total assets
• how effective Company makes use on its assets
• higher ratio = more revenue per asset dollar 
9. Operating cycle = AR turnover in days + Inventory turnover in days
• indicates the number of days between the acquisition of inventory & the realization of cash from selling the inventory
• "cash to cash" cycle
10. Gross margin = revenue - cost
11. Gross margin % = Gross margin / Net sales 
12. Net profit margin %
• Net income / Net sales
• profit rate
13. Net operating margin percentage = Net operating income / Net sales
14. Return on total assets
• Net income / Average total assets
• effectiveness in using resources
• higher ratio = more earning profits per asset dollar
15. Return on equity
• Net income / Stockholders' equity
• return earned by stockholders

Audit Reports

1. Unqualified Opinion - financial statements are presented fairly without material error
• terms: "present fairly"
2. Qualified Opinion - financial statements are presented fairly except for certain matters that have deviated from GAAP/GAAS
• no misrepresentation have been identified 
• additional paragraph to highlight why report is not an unqualified opinion
• terms: "except for"
3. Adverse Opinion - material departure from GAAP
• financial statements are materially misstated as a whole
• worst opinion!
• terms: "do not present fairly"
4. Disclaimer of Opinion - material departure from GAAS 
• auditor is unable to obtain sufficient, appropriate audit evidence 
• auditor does not express an opinion 
• terms: "engaged to audit", "not able to obtain" 
• auditor is associated with FS of a public company but has not audited/reviewed the statements

Withdraw - false, fraud, deceptive, misleading!

Emphasis-of-Matter Paragraph: refers to some aspect of the financial information included in the financial statements

Other-Matter Paragraph: refers to some aspect of the financial information that is not explicitly included in the financial statements

Key 401K People

• Participant - person in the plan; considered to be active if received contributions during the year
• Plan sponsor - employer who sets up the plan
• Plan Administrator - responsible for running the plan
• duties include: appointing legal, filing returns, reviewing, directing, etc. 
• typically the employer unless otherwise appointed/hired by the employer
• Third Party Administrator - an entity/organization/firm hired by the employer to assist in actual Plan Administrator
• duties include: designing, producing, amending, and restating plan documents; assist in processing transactions, testing the plan, etc.
• Trustee - someone who has exclusive authority and discretion to manage & control Plan assets
• duties include: making decisions regarding investments and managing the assets 
• Custodian - the entity that has physical control of contents of the plan
• duties include: protecting assets from theft and keeping it secure

Reference: IRS Definitions for Employee Benefit Plans